In this paper I explore the role of signalling in the agency conflict that pits national governments against international lenders in the Mexican peso crisis of 1994. (The term international lenders includes domestic residents with the capacity to invest abroad.) I give evidence for the conventional conclusion that Mexico`s underlying economic and financial situation did not warrant the humiliating treatment inflicted on it by the international financial markets. The humiliating treatment, however, was not a mindless overreaction to suddenly perceived changes in the country`s political fragility. On the contrary, I show that the country`s evolving political fragility was recognized and compensated for as far back as 1991. It was rather the result of a rational reevaluating of the costs of the agency conflict that is inherent in the relationship between national governments through moratoriums, repudiation, or default to subordinate the claims of international lenders to thos of domestic agents. I model the conflict as a government held option to default and introduce signalling by assuming that the economy`s true situation. I then give evidence that the agency costs were reevaluated when it became clear that the Mexican government had been snding false signals to the international investment community an that these false signals had made it possible for Mexico to borrow close to or beyond the point where default was the optimal financial strategy

Volume 23

Numbers 5-8